Finance

Socialising LossesC.P. Chandrasekhar

October 10, 2008

Despite its second round passage, the collapse of the first-round vote in the US Congress on a package to use $700 billion of public money to bail out firms threatened by the fall-out of the sub-prime crisis has two lessons. First, that the White House, the Treasury and the Federal Reserve, who were saying that intervention was inevitable to avoid a financial meltdown, were making the case for a specific kind of intervention that favoured Wall Street but ignored Main Street. Having made huge profits on speculation, Big Finance wanted the State to pick up the losses when the bubble burst. Second, it showed that whether the advocates of neo-liberalism were willing to accept it or not, this was the end of the neoliberal era, with the neoconservatives deciding that there was no option other than bringing the State back in. Their effort was to do so without giving the State a role in regulating capital. The collapse and subsequent adjustments to the bill indicates that they have failed.

The final version of the Bill, which reflected a deal between Democrat and Republican negotiators, included some modifications of and additions to the outrageous demands originally made by the U.S. administration and the Federal Reserve. These changes were necessitated by the reservations expressed by both Democrats and Republicans pressured by criticism from their constituents that the deal planned to use taxpayers’ money to bail out financial players who profited at the expense of the system.

Despite the modifications, this is a bailout deal that was not warranted. It is indeed true that the U.S. has in hand a serious financial crisis, whose arrival was recognised rather late by a conservative administration, which along with its predecessors was responsible for adopting policies encouraging the practices that led to the crisis. It waited until the sub-prime mess precipitated a credit crunch, with banks unwilling to lend for fear of being loaded with more worthless financial assets. As a result, the “toxic waste” consisting of mortgage-related or mortgage-backed securities is threatening the viability of a range of financial institutions and whole segments of the financial system.

So, intervention by the state to stall a crisis, which, in the words of Warren Buffet, could be “the biggest financial meltdown in American history” was necessary and unavoidable. Unfortunately, however, the bailout in its current form does little to ensure that those responsible for the crisis are penalised, does not put in place regulatory institutions and conditions that could pre-empt similar crises in the future, and is, for a number of reasons, unlikely to deliver a resolution of the crisis reflected in bankruptcies, bailouts, acquisitions and mergers.

It is surprising, therefore, that Democrats, who dominate Congress, while rejecting the request from a lame-duck President for a blank cheque with a huge spending limit and few conditions attached, backed the main contours of the original draft Bill and acceded to many of the demands of the George W. Bush administration.

One explanation is that this was an effort on the part of the Democrats to show that they would not use their majority to stall immediate intervention when the system faces a crisis, even if that crisis was of the Republicans’ making. Eventually, it was the Republican caucus that stalled the administration’s Bill in the first round, on the grounds that it violated all the free-market principles that conservatives claim to stand for. Many Republicans did not want to be seen as endorsing the view that it was the market-friendly push by past and current Republican administrations that precipitated this crisis.

But many Democrats, too, are supporters of liberal financial policies. Therefore, bipartisan support for the Bill was in all probability reflective of the recognition by both Democrats and Republicans alike that unless something was done to stall the unfolding crisis, a return to intense regulation was inevitable.

Worthless assets

But, in all probability, the only comprehensive plan the Treasury had put on the table to resolve the crisis will fail to deliver. What the plan does is give the Treasury (and its private financial advisers, including players who contributed to the crisis) the power to buy not just the near-worthless or “impaired” mortgage-related assets from financial institutions but also any other assets from any other party so as to “unclog” their balance sheets and get credit moving. Implicit in this view is that there are two kinds of securities.

One kind consists of those that have lost value because the mortgages or other loans they are backed with are subject to defaults on payments, leading to foreclosures in a market where the values of those assets are falling. The second kind consists of those that have lost value or whose value is unknown because the credit crunch has frozen the market for these securities, leaving them with no estimable market value. With some assets being worthless and others being of unidentifiable value, it is argued, the viability of many financial firms is in question, depriving them of the funds needed to keep their business going.

The Treasury view, backed by the Federal Reserve, is that if financial institutions were relieved of the first set of securities, their balance sheets would improve and they would be in a position to resume trading or lending and the values of the second set of securities would automatically improve and stand revealed, resulting in a further improvement in the balance sheets of the institutions holding them. This, it is argued, would return credit and asset markets to normality, restore values of “unimpaired” or frozen securities, and stop the wave of bankruptcies, state takeovers, acquisitions and forced mergers that have transformed the U.S.’ financial landscape over the last month.

It would also, supposedly, restore the value of many of the securities acquired by the government, allowing it to sell them and recoup the taxpayers’ money that was to be used to finance this bailout of institutions that failed or are performing poorly because of lack of due diligence and transparency, unsound and excessively speculative financial practices or even sheer malpractice. In a move aimed at indicating that the requirements of taxpayers are being taken care of, the final draft required the President to work out means to recover any losses that would be incurred after five years in the sale of assets acquired under the programme.

The problem is that the information available in the Bill on the bailout is inadequate to answer a number of questions. First, which would be the securities that the government would buy out and to what extent?

The $700 billion figure was the limit set for acquisitions of the troubled assets, whose total value has been guesstimated at upwards of $3 trillion.

That figure would have been even higher had the Treasury been given the discretion to add on any other assets it considers worthy of similar support. It should be expected that the money would be used to buy the worst assets and “unclog” the system so that the less impaired and frozen securities can find their value. The private financial sector too would lobby for such a move since the worst assets are the securities they want off their books. This implies that the assumption is that $700 billion is enough to clear the system of these securities though the basis for that assumption is by no means clear.

The second question that arises is the manner in which prices of the securities to be acquired are set. The bailout plan seeks to use market-based methods, including reverse auctions in which sellers looking for a buyer bid down the price at which they are willing to sell their assets. Since the most impaired securities are near worthless, their prices should be closer to zero for every dollar worth of such assets in terms of their accounting or par values. Setting them there would also permit the government to acquire a substantial volume of securities when seeking to unclog the system or to even save a part of the taxpayers’ money it is authorised to spend to achieve this objective.

The problem, however, is that if this were done, the institutions that are selling these assets at near-zero prices would have to take large write-downs onto their balance sheets and reflect these losses. This would undermine their viability and result in failure unless they are recapitalised with an infusion of new funds, as happened in the case of Washington Mutual, a troubled mortgage bank that had to be seized by federal regulators, shut down and then sold off to JPMorgan Chase & Co. This is the largest bank failure in U.S. financial history, yet the going price for Washington Mutual was a mere $1.9 billion, with no payments to holders of $30 billion in debt and preferred stock.

WaMu, as the institution is informally called, had a troubled loan portfolio of $307 billion. JPMorgan expects to write down about $31 billion of bad loans and raise $8 billion in new capital to recapitalise the bank and successfully integrate it into its own operations. There are other instances where recapitalisation is being ensured through an early sell out (Merrill Lynch) or through a large infusion of capital, as happened with Goldman Sachs, which is supported with capital from Warren Buffet.

These experiences have two implications. First, they show that recapitalisation is unavoidable when the asset portfolios of troubled financial institutions are restructured in the face of losses. Second, they also indicate that as long as there are strong financial institutions or investors who can take on the responsibility of recapitalising weaker firms, the market is not so frozen that they would not be able to mobilise the requisite capital for the purpose. If, instead of looking at options of this kind, the administration chooses to buy up assets at low prices without recapitalisation, it may be providing immediate support to beleaguered financial institutions but not resolving the problem that spreading bankruptcy is creating in the system.

One option would be for the government to buy the assets at prices closer to par values on the grounds that the resulting revival in financial markets would render those prices, which may seem absurd in terms of current conditions, sensible in the long run and defensible from the taxpayer’s point of view. Figures as high as 80 cents to the dollar are rumoured to be in circulation. This would mean that financial institutions would be able to take much smaller write-downs and would not need significant recapitalisation. But it also means that the Treasury may have run through the $700 billion rather quickly, even before enough of the “toxic waste” had been cleared.

In fact, many financial firms would be willing to dump even some of their less impaired or good (but frozen) assets at those prices, leaving the worst assets in the system. If this is not to happen, the administration should choose to buy the worst assets at high prices even when better assets are available at the same price. This could invite the criticism that this is misuse of taxpayers’ money unless the $700-billion limit is relaxed, making the whole process open-ended and unsustainable. It is possibly for this reason that Treasury Secretary Henry Paulson, an ex-Goldman Sachs man, tried to protect himself and his successors in the first of the drafts of the legislation that was to define and authorise the scheme.

In the words of The New York Times, the original draft gave the Treasury Secretary “the authority to buy any assets from any financial institution at any price that he deemed necessary to provide stability to the financial markets”. The draft also asserted “that neither the courts nor any administrative agency would be allowed to question or review these decisions”. The recovery scheme was based on the premise that an appropriate set of bets could pull U.S. financial markets back from the brink of disaster. So the person placing those bets must be free of any fear that failure would make him responsible for burning taxpayers’ money. Unfortunately, the chances of failure are substantial. No Congress can hand over such powers without oversight, which has been allowed for in the final law.

The problem was not that there were no better options. One would have been to combine some state support with market-mediated solutions, which would reduce the cost to the taxpayer of a process of financial restructuring. The JPMorgan Chase takeover of WaMu showed that the latter was possible. Many other options have also been offered and discussed.

Thus, James Galbraith, a Professor of Economics at Austin Texas (and son of the well-known John Kenneth Galbraith), suggested that since the large, purely investment bank that is not subject to capital requirements and is more leveraged is now non-existent (with the closure of Bear Stearns and Lehman Brothers, the merger of Merrill Lynch with Bank of America and the conversion of Goldman Sachs and Morgan Stanley into bank-holding companies), the task of managing the current financial distress could have been given to the Federal Deposit Insurance Corporation. It could have been offered a substantial part of the $700 billion to insure deposits even in excess of the currently specified $100,000, foreclosing bank runs and attracting capital that could help banks recapitalise themselves. Where matters are more difficult, a part of the money could be directly used for recapitalisation of the institutions concerned, with share ownership going to the government.

Getting share ownership for the government when bailing out banks was a strategy adopted by the Swedish government after its banking crisis in 1992. It got banks to write down losses, required shareholders as opposed to taxpayers to carry much of the burden and offered bailout funds in exchange for equity. Equity ownership gave taxpayers the hope of some returns when distressed assets were sold or when shares were sold after successful restructuring.

There were some improvements in the final version of the Bill, however. It recognised that if taxpayers’ money was being used, they should not merely be offered the promise that this burden would be neutralised when the government recoups the money through the sale of acquired assets when market normality is restored, but a stake in the banks they are bailing out so that they can exercise both some supervision of the use of their money as well as have the choice of retaining an equity stake if these banks survive and recover.

It accepted the need to regulate and tax executive compensation and severance packages in firms supported by the government. And it provided for congressional oversight, with the proviso that bailout financing would be released in three stages, starting with an initial $250 billion. Congress was to have the right to vote to hold back a final tranche of $350 billion if the funds were not being used effectively.

Finally, the bailout recognised the importance of backing homeowners whose now-much-cheaper houses are being foreclosed because they cannot keep to payments commitments on mortgages that reflect the high values of the property boom years and involve extremely high interest payments. The Treasury, as owner of mortgages it has bought up, can attempt to reduce foreclosures by trimming the principal, cutting the interest rate or increasing the payback period on mortgages. Besides being fair in itself, the use of some of the money to help homeowners retain their assets may have salutary effects on consumption demand, which could limit the collateral damage of this financial disaster on growth and employment.

All this notwithstanding, this historically unprecedented bailout was one that subsidised finance, underwrote losses generated by market forces, and left most others directly or indirectly affected by the excesses of the mortgage-lending boom untouched. It is partly to meet such criticism that the Bill provided for the obtaining of compensation from banks and other financial institutions after five years in case the government loses money on the impaired securities it purchases. This assumes that these banks will be in a position to compensate the government even if the securities that the latter took over are not performing well. They probably will not be.

Thus, there are reasons to believe that the current package in the Bill will fail to address the crisis adequately and restore stability. Meanwhile, globally, markets are in a state of collapse, partly driven by the expectations generated by the scaremongering used to push through the package. The danger is that those threats may actually be realised.